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Short This Stock

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There are just eight days left until we’ll have the first-quarter winner of our CAPS Champion of the World Contest. With a strong finish many players are still within striking distance of the prize, so this thing is far from settled. But even if you haven’t entered yet, or have some catching up to do, we still have nine months until we award the grand prize, so sign up here, if you haven’t already. And now, this week's idea from GG co-advisor Nathan Parmelee...

Just about everything China-related has been on a tear the last few months and the market hasn’t reached the point where it separates the high-quality businesses from the pretenders. But it will, because as Ben Graham noted, the market is a voting machine in the near-term and a weighing machine in the long-term. My idea for this week comes up more than few pounds short on the valuation front, and should prove a profitable short.

Short Fuqi International (FUQI)Thesis

Fuqi International has shown explosive revenue and earnings per share growth over the last few years, but with Fuqi International all that glitters isn’t gold. For every dollar of earnings growth Fuqi creates it consumes at least $0.50 in cash to support its working capital for expansion -- and in some years more than the dollar in earnings it created. So what looks cheap on the surface isn’t a bargain at all. In fact, the secondary offering completed by the company last week is a perfect example of how this high growth company needs plenty of cash financing fuel to its growth.

Business description

China-based Fuqi International designs and makes jewelry from gold, platinum, and other precious metals and stones. The majority of its business is as a supplier of luxury jewelry to distributors, wholesalers, and retailers throughout China, but in 2007 it moved into running its own chain of retail stores with a focus on diamond jewelry and other precious materials. In the past working these products were special orders Fuqi fulfilled for its customers. However with the 2007 acquisition of Temix, Fuqi picked up 7 stand-alone stores and 43 counters in department stores where it sells some of its designs directly to customers.

A silly valuation

At 16.7 times earnings (or about 20 after the secondary offering) Fuqi’s shares don’t look all that expensive. It’s 13x EV/EBITDA multiple hints at how expensive it is, but it’s when you really start poking around under the hood at cash management that Fuqi starts to look much more expensive.

In the last twelve months Fuqi generated $31.1 million in net income, but only $16.5 million in operating cash flow and just $15.4 million in free cash flow. So what looks reasonable at 17x-20x earnings is actually selling for close to 40x free cash flow. Investment in inventory and slow collections of accounts receivable are the culprit as Fuqi’s cash conversion cycle has nearly doubled from 57 days in 2006 to 110 days today, and in the last three-plus years Fuqi’s operating cash flow has consistently trailed its earnings. All these qualities are classic red flags of an unsustainable growth model. A more reasonable valuation for Fuqi is about 15x operating cash flow, which makes it substantially over-valued at $24 per share.

Give this one a thumbs down, and pick up some easy points in the next 9 months.

I mean, the business in itself does not appear bad, broken, or otherwise disfunctional. It has simply gotten a bit pricey... and could stay pricey... for a very long time... maybe enough time for fundamentals to catch up to the equity price? Better, I think, to only short goods that are overpriced AND damaged in some way or other.

What about their improving margins? Certainly there are risks associated with any business expanding so rapidly, but one thing that makes me feel more comfortable is that fact that--as they are expanding further into the retail side--their margins grow along with their revenue. Given this, I hesitate to sell for under $30ps, and I would never consider shorting it.

I hear you on cash conversion, but I think it is to be expected. (Really)

- We're all in Recession (East and West), Accts Rec is going to balloon.

- As the Buffett link points out, the retail end of the jewelry biz is truly mediocre. Inventory investment for each new location is huge and the inventory turns are poor. So, as Fuqi expands retail operations, certain metrics are going to become and remain ugly.

Though as blaueskobalt notes, the pay-off for their efforts is an expanding margin in the retail end of operations. Yeah, ROIC will suffer... but at the end of the day, Fuqi gets a bigger footprint in its markets, Execs get paid more for expanding operations, and investors get a bigger pizza with a whole lot less cheese on top.

So, I still say this is the wrong pizza to short. Investors will continue to be inspired by the increasing size, even as the toppings become less appetizing. :~)

Tim, I appreciate all the research, due diligence, hard work and opinionating that you and the rest of the Fools do, especially in the more difficult-to-grasp international markets. With FUQI at $26 and change, I will respectfully disagree with your conclusions based upon my four following rationales:

1. It is my understanding that FUQI's recent new activities (and blueprint for further expansion) are to open more jewelry counters in established retail malls. You mentioned the 7 stand-alone store and the 43 counters opened in 2007. It seems that they are drifting away from the high CapEx of building bricks-and-mortar operations.

2. You cite increases in inventory and receivables. If these were extraordinary and ongoing without actual increases in sales, I would agree with you that they should be avoided. Instead, I side with the above comment of CaveatEmptorFool (or perhaps I'm reading more into his comment than what he actually said) that this is a natural consequence of a growing business. Personally, I think that this gives management an opportunity to focus and improve on this area of its business. It might take another fiscal quarter or two to see if sales growth begins to stagnate or if margins become problematic. Right now, neither seem to be the case.

3. This company directly reaches into a market of increasing demand as millions (if not billions) of aspiring Chinese begin to attain middle-class status. It is a local (Chinese owned and operated) brand with a strong reputation (there in China) filling a growing need. In my opinion, this is the sweet spot of the tennis raquet, the middle of the faiway, the fat part of the baseball bat ... I'm sorry that I don't know anything about soccer, otherwise I'd throw in an analogy there, too.

4. Unrelated to the analysis on this company, I messed up. Without due diligence or thought on my part, I screwed up - I trusted you. It's not really your fault, so much as it is all mine. In the words of George Costanza: "It's not you. It's me."

Not only would I not short this stock, I do not foresee FUQI trading below its current price at yearend (regardless of the direction that the S&P may go), unless there is a massive global catastrophic occurrence (something akin to millions of people suddenly dying from a plague or flu epidemic, the outbreak of World War 3, a moon-sized asteroid crashing into the Pacific Ocean, or the Klingons avoiding assimilation and overtaking the Borg). Short of that, this pick's stock price should be in the 30's.

Disclosure: I green-thumbed this pick in CAPS several months ago. I do not own shares of this in real life.

It's hard to short a stock that has already generated more than 100% actualized returns for me on Sept option calls... I'm not into the "hey this stock is not fundamentally sound," plugs... I do not know very many people who follow fundamentals that are filthy rich... I know a few who lie about fundamentals and become filthy rich (think Countrywide CEO)... I will stick with the technicals... Charts do not lie... TREND FOLLOWING is my game... I make money no matter where we go... up.. down.. sideways... I don't know very many stocks that corrected this week and still posted a $3 run at weeks end... And it continues to be the Investor Business Daily's IBD 100 #1 stock... Unbiased computers pick these top 100 stocks.. Not humans with their selfish agendas.. Let's make some money....shall we??? And Rumble on RHINO style...

The investment style for the main Eclectica fund is broad — any asset category goes — and the approach unconventional. Mr Hendry never looks at brokers’ research, never meets company managements and is deeply sceptical of daily news flow. The style seems contradictory at times. He believes in not following the herd, yet he has an enormous respect for the market. The Eclectica website proclaims: “The market has infinite wisdom; it is divine.”